Turns out policymakers were good, but also got lucky
The U.S. economy has been far more successful at recovering from the COVID-19 shock than it was in dealing with the aftermath of the housing bubble of the 2000s. As I noted in my latest column, four years after the 2007-09 recession began, employment was still 5 million below its prerecession peak. This time it’s up by almost 6 million.
And although there was a wave of inflation, it seems to have broken. This is especially clear if you measure inflation the way other countries do. The harmonized index of consumer prices differs from the regular consumer price index in that it doesn’t include owners’ equivalent rent, an imputed cost of housing that nobody actually pays and is very much a lagging indicator; and by this measure inflation has been cut to about 2%, the Federal Reserve’s inflation target.
Basically, the U.S. rapidly restored full employment while experiencing a one-time jump in the level of prices without a sustained rise in inflation, the rate at which prices are rising. Not bad, especially considering all the dire predictions made along the way.
But could we have done better? And to the extent that we got it right, were we just lucky?
My take is that we did very well, that the U.S. response to the COVID-19 shock was, in retrospect, fairly close to optimal. But the miracle of 2023, the combination of rapid disinflation with a strong economy, was sort of an accident. Policymakers thought that raising interest rates would cause a recession and raised them anyway because they thought such a recession was necessary. Fortunately, they were wrong on both counts.
What do I mean by saying that policy was close to optimal? COVID-19 disrupted the economy in ways previously associated only with wartime mobilization and demobilization: There was a sudden large change in the composition of demand, with consumers shifting away from in-person services and buying more physical stuff, a shift enlarged and perpetuated by the rise of remote work. The economy couldn’t adapt quickly to this shift, so we found ourselves facing supply-chain problems — inadequate ability to deliver goods — together with excess capacity in services.
How should policy respond? There was a clear case — nicely formalized in a 2021 paper by Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub and
Ivan Werning presented at the Fed’s Jackson Hole, Wyo., conference that year — for strongly expansionary monetary and fiscal policy that limited job losses in the service sector, even though this would mean a temporary rise in inflation. And that’s more or less what happened.
The big risk in following such a policy was the possibility that the rise in inflation wouldn’t be temporary, that inflation would become entrenched in the economy and that getting it back down would require years of high unemployment. This was the argument infamously made by Larry Summers and others. But that argument turned out to be fundamentally wrong — not just a bad forecast, which happens to everyone, but a misunderstanding of how the economy works. Although inflation lasted longer than Team Transitory expected, it has, as we predicted, subsided without a big rise in unemployment. Notably, inflation never became entrenched in expectations, the way it did in the 1970s.
In fact, America has had the strongest recovery in the advanced world without experiencing significantly higher inflation than other countries.
U.S. policymakers, then, seem to have gotten it more or less right. But as I’ve already suggested, this was arguably a lucky accident.
It’s instructive to look at the projections made by members of the Fed’s Open Market Committee — which sets interest rates — in December 2022 and compare them with what actually happened.
The FOMC had been raising rates since early 2022 in an effort to control inflation, and it’s clear from the projections that members believed that its efforts would cause a recession and that a recession was necessary. Their median projection was that economic growth would almost stall and unemployment would rise by about a percentage point, which would have triggered the Sahm Rule linking rising unemployment to recession. And if growth had actually stalled, it probably would have gone negative, because large growth slowdowns tend to cause sharp declines in business investment.
What actually happened was that the economy proved far more resistant to higher interest rates than the Fed expected, so growth kept chugging along and unemployment didn’t rise significantly. But inflation fell anyway, coming in below the Fed’s projections. So the economy surprised the Fed in two ways, both positive. Disinflation, it turned out, didn’t require a bulge in unemployment; but rate hikes, it turned out, didn’t damage employment as expected.
My view is that the first error, believing that we needed high unemployment, is hard to excuse — there were very good reasons to believe that the 1970s were a bad model for postpandemic inflation — while nobody could have known that the economy would shrug off high rates. But then, I would say that, wouldn’t I, because I didn’t make the first mistake but did make the second.
In any case, the remarkable thing is that these were offsetting errors. The Fed’s error on inflation could have led it to impose a gratuitous recession on an economy that didn’t need it, but rate hikes turned out to be appropriate, not to induce a recession but to offset a spending surge that might otherwise have been inflationary. Overall, policy seems to have been about right, creating an economy that was neither too cold, suffering unnecessary unemployment, nor too hot, experiencing inflationary overheating.
Yes: Policymakers stumbled into Goldilocks.
What went right? As I’ve said, the claim that inflation would be hard to tame never made much sense given what we knew. The economy’s resilience in the face of high interest rates is harder to explain, although a driving force may have been immigration: Slow population growth was one popular explanation of secular stagnation, so an influx of working-age adults may have been just what we needed.
I guess the larger point is that in macroeconomics as in life, it’s important to be good, but also very important to be lucky. And we got lucky this time.